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each year.
Bodie’Kane’Marcus: III. Debt Securities 9. Bond Prices and Yields © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




303
9 Bond Prices and Yields


Inflation in Coupon Principal Total
TA B L E 9.1
Time Year Just Ended Par Value Payment Repayment Payment
Principal and
interest payments 0 $1,000.00
for a Treasury 1 2% 1,020.00 $40.80 0 $ 40.80
Inflation 2 3 1,050.60 42.02 0 42.02
Protected 3 1 1,061.11 42.44 $1,061.11 1,103.55
Security




The real rate of return is precisely the 4% real yield on the bond:
1 Nominal return 1.0608
Real return 1 .04, or 4%
1 Inflation 1.02

One can show in a similar manner (see problem 12 in the end-of-chapter questions) that the
rate of return in each of the three years is 4% as long as the real yield on the bond remains
constant. If real yields do change, then there will be capital gains or losses on the bond. In
mid-2002, the real yield on TIPS bonds was about 2.5%.


9.2 BOND PRICING
Because a bond™s coupon and principal repayments all occur months or years in the future, the
price an investor would be willing to pay for a claim to those payments depends on the value
of dollars to be received in the future compared to dollars in hand today. This “present value”
calculation depends in turn on market interest rates. As we saw in Chapter 5, the nominal risk-
free interest rate equals the sum of (1) a real risk-free rate of return and (2) a premium above
the real rate to compensate for expected inflation. In addition, because most bonds are not
riskless, the discount rate will embody an additional premium that reflects bond-specific char-
acteristics such as default risk, liquidity, tax attributes, call risk, and so on.
We simplify for now by assuming there is one interest rate that is appropriate for discount-
ing cash flows of any maturity, but we can relax this assumption easily. In practice, there may
be different discount rates for cash flows accruing in different periods. For the time being,
however, we ignore this refinement.
To value a security, we discount its expected cash flows by the appropriate discount rate.
The cash flows from a bond consist of coupon payments until the maturity date plus the final
payment of par value. Therefore

Bond value Present value of coupons Present value of par value
If we call the maturity date T and call the discount rate r, the bond value can be written as

Coupon Par value
T
Bond value (9.1)
(1 r)t (1 r)T
t 1


The summation sign in Equation 9.1 directs us to add the present value of each coupon pay-
ment; each coupon is discounted based on the time until it will be paid. The first term on the
right-hand side of Equation 9.1 is the present value of an annuity. The second term is the pres-
ent value of a single amount, the final payment of the bond™s par value.
You may recall from an introductory finance class that the present value of a $1 annuity

( )
1 1
that lasts for T periods when the interest rate equals r is r 1 (1 r)T . We call this
Bodie’Kane’Marcus: III. Debt Securities 9. Bond Prices and Yields © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




304 Part THREE Debt Securities


1
expression the T-period annuity factor for an interest rate of r.3 Similarly, we call (1 r)T the
PV factor, i.e., the present value of a single payment of $1 to be received in T periods. There-
fore, we can write the price of the bond as

( )
1 1 1
Price Coupon 1 Par value (9.2)
r r)T r)T
(1 (1
Coupon Annuity factor(r, T ) Par value PV factor(r, T )


We discussed earlier an 8% coupon, 30-year maturity bond with par value of $1,000 paying
60 semiannual coupon payments of $40 each. Suppose that the interest rate is 8% annually,
9.2 EXAMPLE or r 4% per six-month period. Then the value of the bond can be written as
60
Bond Pricing $40 $1,000
Price
(1.04)t (1.04)60
t 1

$40 Annuity factor(4%, 60) $1,000 PV factor(4%, 60)
It is easy to confirm that the present value of the bond™s 60 semiannual coupon payments
of $40 each is $904.94, and that the $1,000 final payment of par value has a present value of
$95.06, for a total bond value of $1,000. You can calculate the value directly from Equation
9.2, perform these calculations on any financial calculator,4 or use a set of present value tables.
In this example, the coupon rate equals the market interest rate, and the bond price
equals par value. If the interest rate were not equal to the bond™s coupon rate, the bond
would not sell at par value. For example, if the interest rate were to rise to 10% (5% per six
months), the bond™s price would fall by $189.29, to $810.71, as follows
$40 Annuity factor (5%, 60) $1,000 PV factor(5%, 60)
$757.17 $53.54 $810.71


At a higher interest rate, the present value of the payments to be received by the bondholder
is lower. Therefore, the bond price will fall as market interest rates rise. This illustrates a cru-
cial general rule in bond valuation. When interest rates rise, bond prices must fall because the
present value of the bond™s payments is obtained by discounting at a higher interest rate.
Figure 9.3 shows the price of the 30-year, 8% coupon bond for a range of interest rates in-
cluding 8%, at which the bond sells at par, and 10%, at which it sells for $810.71. The nega-
tive slope illustrates the inverse relationship between prices and yields. Note also from the
figure (and from Table 9.2) that the shape of the curve implies that an increase in the interest

3
Here is a quick derivation of the formula for the present value of an annuity. An annuity lasting T periods can be viewed
as an equivalent to a perpetuity whose first payment comes at the end of the current period less another perpetuity whose
first payment doesn™t come until the end of period T 1. The immediate perpetuity net of the delayed perpetuity pro-
vides exactly T payments. We know that the value of a $1 per period perpetuity is $1/r. Therefore, the present value of
1 1
the delayed perpetuity is $1/r discounted for T additional periods, or . The present value of the annuity is
r (1 r)T

( )
1 1
the presentvalue of the first perpetuity minus the present value of the delayed perpetuity, or 1 .
(1 r)T
r
4
On your financial calculator, you would enter the following inputs: n (number of periods) 60; FV (face or future
value) 1000; PMT (payment each period) 40; i (per period interest rate) 4%; then you would compute the
price of the bond (COMP PV or CPT PV). You should find that the price is $1,000. Actually, most calculators will dis-
play the result as minus $1,000. This is because most (but not all) calculators treat the initial purchase price of the
bond as a cash outflow. We will discuss financial calculators more fully in a few pages.
Bodie’Kane’Marcus: III. Debt Securities 9. Bond Prices and Yields © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




305
9 Bond Prices and Yields




$3,500


$3,000


$2,500
Bond price




$2,000


$1,500


$1,000
$810.71

$500


$0
0% 5% 10% 15% 20%

Interest rate




F I G U R E 9.3
The inverse relationship between bond prices and yields. Price of an 8% coupon bond with 30-year maturity making
semiannual coupon payments.



Bond Price at Given Market Interest Rate
TA B L E 9.2
Time to Maturity 4% 6% 8% 10% 12%
Bond prices
at different
1 year $1,038.83 $1,019.13 $1,000.00 $981.41 $963.33
interest rates (8%
10 years 1,327.03 1,148.77 1,000.00 875.38 770.60
coupon bond,
20 years 1,547.11 1,231.15 1,000.00 828.41 699.07
coupons paid
30 years 1,695.22 1,276.76 1,000.00 810.71 676.77
semiannually)




rate results in a price decline that is smaller than the price gain resulting from a decrease of
equal magnitude in the interest rate. This property of bond prices is called convexity because
of the convex shape of the bond price curve. This curvature reflects the fact that progressive
increases in the interest rate result in progressively smaller reductions in the bond price.5
Therefore, the price curve becomes flatter at higher interest rates. We will return to the issue
of convexity in the next chapter.

5
The progressively smaller impact of interest rate increases results from the fact that at higher rates the bond is worth
less. Therefore, an additional increase in rates operates on a smaller initial base, resulting in a smaller price reduction.
Bodie’Kane’Marcus: III. Debt Securities 9. Bond Prices and Yields © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition




306 Part THREE Debt Securities



>
2. Calculate the price of the bond for a market interest rate of 3% per half year. Com-
Concept
pare the capital gains for the interest rate decline to the losses incurred when the
CHECK rate increases to 5%.
Corporate bonds typically are issued at par value. This means the underwriters of the bond
issue (the firms that market the bonds to the public for the issuing corporation) must choose a
coupon rate that very closely approximates market yields. In a primary issue of bonds, the
underwriters attempt to sell the newly issued bonds directly to their customers. If the coupon
rate is inadequate, investors will not pay par value for the bonds.
After the bonds are issued, bondholders may buy or sell bonds in secondary markets, such
as the one operated by the New York Stock Exchange or the over-the-counter market, where
most bonds trade. In these secondary markets, bond prices move in accordance with market
forces. The bond prices fluctuate inversely with the market interest rate.
The inverse relationship between price and yield is a central feature of fixed-income secu-
rities. Interest rate fluctuations represent the main source of risk in the bond market, and we
devote considerable attention in the next chapter to assessing the sensitivity of bond prices to
market yields. For now, however, it is sufficient to highlight one key factor that determines
that sensitivity, namely, the maturity of the bond.
A general rule in evaluating bond price risk is that, keeping all other factors the same, the
longer the maturity of the bond, the greater the sensitivity of its price to fluctuations in the in-
terest rate. For example, consider Table 9.2, which presents the price of an 8% coupon bond
at different market yields and times to maturity. For any departure of the interest rate from 8%
(the rate at which the bond sells at par value), the change in the bond price is smaller for
shorter times to maturity.
This makes sense. If you buy the bond at par with an 8% coupon rate, and market rates sub-
sequently rise, then you suffer a loss: You have tied up your money earning 8% when alterna-
tive investments offer higher returns. This is reflected in a capital loss on the bond”a fall in
its market price. The longer the period for which your money is tied up, the greater the loss
and, correspondingly, the greater the drop in the bond price. In Table 9.2, the row for one-year
maturity bonds shows little price sensitivity”that is, with only one year™s earnings at stake,
changes in interest rates are not too threatening. But for 30-year maturity bonds, interest rate
swings have a large impact on bond prices.
This is why short-term Treasury securities such as T-bills are considered to be the safest.
They are free not only of default risk but also largely of price risk attributable to interest rate

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